Monday, May 2, 2011

The scuttlebutt method of stock research

Phillip Fisher – one of the great investment gurus of all time – used to talk about the “scuttlebutt method” - just finding out what is really going on in companies by asking customers, suppliers and competitors. Information that comes from the company is either inside, self-serving or both. Sure you need to read and analyse accounts but real information – stuff you dredge up on your own – creates an edge. Obviously if that real information comes from paying insiders (or supplying sexual favors to insiders) then trading on that information is illegal (and the SEC/FBI are getting a string of guilty pleas).

However this is a post about research methods that might be used by semi-professional investors – those that could not afford the services of the “expert networks” at the core of the current batch of insider trading cases. I am exploring what might be a common position after some (really diligent) research. It is a position we find ourselves in.

We know a company with a moderate market capitalization (a few hundred million dollars). There is no short interest – and there are (highly) reputable people on the board. Board members “check out”. Nobody has a history in pump-and-dump schemes – the board seems suitable.

The stock is widely distributed having been well promoted by regional stock brokers. Whilst the stock has been weak for a long time nobody has shorted the stock because the upside if the technology works is very large. Given this is an adventurous technology I would normally expect it to fail – and the company to fade into obscurity. Most adventurous technologies fail – and failure does not reflect badly on management. Still the management is upbeat and a bullish release is made about once a month.

The company is not located in well-known technology centre – its in somewhere like Kansas rather than somewhere like San Jose. Indeed there would be almost no cross-fertilisation with other companies in this industry because there are no competitor companies for hundreds of miles around.

The company sounds promising. It is in a major industry (with a huge end market). The technology was mainly developed by the founder. The industry (more broadly) is conducting a lot of research and development along a lot of distinct technological lines. None of the serious players seems very interested in this line. Nonetheless the technology has had favorable mentions in top-class science publications (like Nature). Cumulative R&D spend is about $30 million which the company has raised by issuing stock. The founding CEO claims a PhD from in a relevant area from one of the top universities in the world. (I have not checked this PhD was actually awarded.)

The company has a factory which has a working (and clearly polluting) smoke stack. (I know because I paid someone to observe it.) The company is however primarily an R&D shop so you would expect typical nerds to work there – starting late and ending very late (tech geeks keep often keep very odd hours). However my spy tells me the car park is largely empty by 5pm which is unusual in a tech-research company where the end-goal is to change the world.

The company has sales – but the sales are to another R&D company in the same (relatively obscure) sub-branch of the industry. There are no sales to real end customers but the company touts its sales. The product is – as far as I can tell – not in commercial use though pictures of samples are on the website. Ambitious technical claims have appeared – and later disappeared – from the corporate website. I have – through a proxy – asked for a sample and not been given one. The proxy would normally expect to receive a sample as he is potentially a large end-user.

The founding-CEO was CEO for about a decade. He is now just shy of 50. He became executive chairman a while ago and appointed a guy with a fine manufacturing career as CEO – but the manufacturing career is from a completely unrelated industry. That CEO lasted about two years before he moved to a lower paying (although still CEO) job. He gave up his options without much dispute. The founding-CEO claims to be involved and claims to be attending all the board meetings.

Now I discover the founding-CEO is living with his mistress more than twelve hours flight from the working-class locale of the main R&D shop. The mistress is substantially younger and the new locale is exotic (think South of France, Tahiti or Byron Bay Australia or similar). The mistress has a daughter by an earlier relationship and hundreds of thousands of dollars are spent on the daughter's glamorous hobbies and lifestyle.

Finally the founding-CEO's teenage son hangs around the original town and uses a high-priced sports car to (seemingly successfully) attract girls. Money drips out of the son's pocket and the son has an entitled demeanor. The dad of one of said girls is suspicious – but maybe he is only protecting his daughter.

Knowing only this much about the company how much weight would you put on the founding-CEO's lifestyle decision as to whether to go long or short the stock?

My second question: suppose you met this founder-CEO in the lounge at the airport waiting for the first-class flight to the above exotic location. Because of your interest in this company you recognise the founder-CEO from the photo in the annual report. You find out in casual conversation that the founder-CEO was going “home” to the exotic location. Most the rest of the material you found by befriending people on Facebook (using your real name). Would this method of research be kosher?

Finally – is this what Phillip Fisher (Common Stocks and Uncommon Profits) thought of as the “scuttlebutt method”? What is the line between what Phillip Fisher thought of as “scuttlebutt” and what the SEC is currently thinking of as insider trading? Is this sort of scuttlebutt sufficient to beat the market anyway?

Thoughts please.

John

PS. Thanks for the correction: Phillip Fisher at the beginning of this article turned into Ken Fisher at the end of the article. I confused father and son.

36 comments:

Anonymous
said...

While no single piece you list is a dealbreaker, the puzzle, taken in totality, might prod one to short. That said, some really slimy operators (i.e. PPD) have longer than I thought they would. Great read, again.

Ten years is a pretty long time for an effort to bring a new technology to market. Since most technological ideas are not unique, this begs the question of whether (a) the technology really works as well as presented (maybe it was Ok in a lab at small scale but not a commercial proposition), and (b) if it does work, do customers really care enough to adopt.

In this case, it seems that after trying for 10 years, the founder gave up is basically cashing out his equity stake.

More broadly on the subject of "scuttlebutt", it seems that the type of research you are doing is EXACTLY what analysts should (but are often to lazy to) be doing. Essentially, you are trading on the edge that comes from being willing to do the work.

The only potentially questionable (in the "non public" sense) fact here is the conversation with the CEO. Since the only fact elicited here is location of "home", and this is something that should be public knowledge, there doesn't seem to be much of an issue. (It should be noted though, that in this day "reasonableness" doesn't seem to be a criteria SEC uses in decision making).

From CFA Ethical and Professional Standards(Standard II.A - Material Non Public Information).Mosaic TheoryInsider trading violations should not result when a perceptive analyst reaches a conclusion about a corporate action or event through an analysis of public information and items of nonmaterial nonpublic information (i.e., a "mosaic" of information).

Under mosaic theory, financial analysts are free to act without risking liability. That is, a financial analyst may use nonpublic information as the basis for investment recommendations and decisions even if that conclusion would have been material inside information had they been communicated directly to the analyst by a company.

I have worked as R&D (Telco) engineer. I don't think when people go home is a good indicator of the quality (or lack of) of R&D. These days you can do anything from home - just a VPN away. I knew the people in my company at the Denver R&D location all go home at 4:00 pm but they come in crazy early. New Jersey keeps different times too.

May be a search of patents on USPTO? Although not knowing what the industry is it's hard to say if patents are a good indicator also.

John, in your experience, how often have you ever encountered a company where financial malfeasance (e.g. embezzlement, commercial misrepresentation) came "out of the blue", i.e. there were no warning signs whatsoever (setting aside scuttlebutt as you had raised)?

I ask this because I honestly don't know how often "smokeless fires" happen on the corporate landscape where the sort of scuttlebutt raised in this article is all the signs that ever were before things blew up.

Another excellent post - not sure I would short given that (as you say) if you are wrong and the technology does work will be very painful.

But does seem legitimate to find out about and question the founder/CEO's lifestyle given lack of commercial success. If he drives a rolls royce and there is a fountain in the court yard then definitely steer clear!

I heard of a coal company that had a flood in one of the big mines. Stock was dropping. My friend called the phone in the mine, talked to the engineer, who was very happy that the flood had been solved and the mine was going back to work. Friend bought big, made some money.

Love the post, makes you think - I think based on your feedback I would.. try to find more information? Without understanding the broad industry tones it's difficult to say whether this strategy can beat the market. The problem is even if it works the ability to replicate the same information flow on a continuing basis.

I might take a small short position and do some more digging.

I think this information clearly falls within the "mosaic theory" approach.. Wonder what the new rulings from the SEC will come back as?

+1 Mosaic theory. All of this is information that would be available to any member of the public who did legal and ethical spade work.

It becomes insider trading if you get a material piece of information from an insider that is not publicly disseminated.

Gets interesting if in the course of doing spade work, you inadvertently encountered info that the CEO expects to be private and/or is supposed to keep secret, ie you see him ducking into a meeting with a potential acquirer.

But any hardware can be controlled remotely. So only a few people needed to be onsite to run the lab facilities. Any R&D (with or without the smokestacks) that generates data then those can be mined remotely also.

John, it would seem the question is one of breadth. Perhaps the CEO is the only one who is fraudulent, but he "knows" it's wrong, and doesn't permit those whom he manages to engage in it. Based upon your post, it doesn't seem like you have established a case for a culture of fraud (whereas you have definitely established that in other successful shorts described on this blog). So how far does he let the fraud go if he is truly fraudulent?

I also don't think your methods are illegal (though I'm not a lawyer), so your only issue is whether or not your are comfortable with them given your morals.

If the hypothesis is that there is fraud, then it seems the question is how far does the fraud extend? Perhaps the CEO is the only one who is fraudulent, but he "knows" it's wrong. Perhaps he is a "protector" (fits with description of the mistress relationship), so he rationalizes his behavior/lifestyle on account of the good he thinks he's doing for his loved ones but would never permit those whom he manages to engage in it. It's a plausible explanation. Based upon your post, it doesn't seem like you have established a case for a culture of fraud (whereas you have definitely established that in other successful shorts described on this blog). So how far does he let the fraud go if he is truly fraudulent?

I also don't think your methods are illegal (though I'm not a lawyer), so your only issue is whether or not your are comfortable with them given your morals.

I wouldn't worry about the 5pm thing too much. It wouldn't surprise me if they were capital-limited on the rate of research (for example, if they have one or two reactors that each take a week to run, and there's not much else to do while it runs).

Based on what you said about the founder, it sounds like he's probably liquidated much of his holdings and semi-retired. Odds are the active management comes from more of a business school background. This can cause all sorts of havoc, as b-school types tend to have unrealistic ideas of how to manage research. For example, in research there's always a lot of uncertainty about what resources and time will be needed to complete the project, and you don't get those answers until the research is finished. This makes ROI impossible to meaningfully calculate, which never stops people from trying.

A theoretically promising approach with a couple of early results has hit a roadblock. They're trying to work through it but it's taking so long that morale is low and now it's just a job. They may own valuable process-type patents which are being used to attract funding, but they no longer have the drive or ideas to capitalize on them and insiders doubt they ever will. Perhaps not outright fraud, but it's at most a lifestyle/wishful thinking company.The methods are legal.. wish someone should had noticed the accountants for Madoff's billion-dollar company were 2 guys in a strip mall.

1) the 5pm thing is a red herring. I would expect the lifestyle in Kansas to be far different from Silicon Valley. Even in Silicon Valley, mature companies have most parking lots half empty at 6pm.2) Don't confuse your business analysis with personal analysis. What the CEO does with his mistress is completely not pertinent to how he runs the company. As well, it is even less related to the stock price. Think about how many current CEOs had issues with fidelity. I think it's another red herring.3) the kid is also spurious. having a spoiled brat as a child is part and parcel of being rich.

One framework fraud investigators use to find situations ripe for fraud is the Fraud Triangle. The legs of the triangle are Incentive/Pressure, Attitude/Rationalization and Opportunity. These are circumstantial markers that might lead an investigator to probe more deeply in a given area. “Incentive/Pressure” covers things like personal bonuses overly tied to a particular metric or an impending do-or-die liquidity event. “Opportunity” involves things like unchecked access to some asset or CEOs with chummy, inattentive boards. The “Attitude/Rationalization” leg covers flashy or unusually egotistical behavior (Kozlowski, Scrushy) or playing fast and loose with the truth. Obviously, just because these conditions exist, doesn’t mean there is a fire; but it does help investigators in determining where to look for smoke.

For me, it sure smells smoky on this one. The CEO seems to be lying to shareholders (but not random airport strangers) about where he spends most of his time. His attitude toward the truth sounds “flexible. You don’t mention the CEO as directly exhibiting flashy behavior, aside from his exotic adopted hometown. However, we might hypothesize that he at least revels in providing a flashy lifestyle to his son and would-be stepdaughter (Pressure or Attiutude). Is the board a bunch of his sleepy buddies? That might give him the freedom he needs for shifty goings-on.

I would definitely dip a toe in on the short side of this. However, I think to go whole hog I would need to be more convinced about the underlying technology. The rest of this stuff is nice smoke, but most of these issues can simply smolder forever. They would *definitely* spur me to keep looking. The stock doesn’t burn to the ground until something or someone grabs the market by the scruff of its neck and holds its face in the steaming pile on the rug that is the company’s (allegedly) fake technology. On the off chance the tech is not rubbish, I’d keep things small until building more confidence about its failure.

With regard to your methods, I think you are nowhere near inappropriate. Nowhere in your story did anyone come close to violating a duty to the company. To my understanding, most of the problem with the expert networks occurred when the experts were disclosing secrets about their own employers (material non-public information - the kinds of things their employers would eventually be expected to issue press releases about). In your example, the CEO’s choice of hometown is not a newsworthy piece of information on its own. What is news is perhaps that he has misled investors as to his day-to-day involvement in the business. But that’s just him getting caught in a lie, not him selectively disclosing earnings or a big impending contract win.

My recollection (several years old) of Phil Fisher is that your work would be quite in line with his definition of scuttlebutt. I’m a little hazy, but perhaps he focused more on industry trends and the actual operations (as opposed to the management team). To my mind though, when you think of buying stocks as an ownership stake in a business, few things are as basic as knowing whether or not you are partnering with a dirtbag. Same goes on the short side. Except there, of course, dirtbags are desirable.

Phillip Fischer was more concerned about talking to customers and suppliers and not doing background checks on management teams. His process was to find the companies with the best management teams creating the most innovative products though talking to suppliers, customers, competitors, etc. This seems more like a short seller's suspicion that a management team is lying. Both are good due diligence, but the comparison I think is off base.

Had I found that the carpark was filled at 9pm. When you took staff or customers for a beer you heard the story about (a) how enthused everyone was (b) how you would hope your kids work there and (c) how the founder is an inspiration for young tech whizzes...

These methods remind me of a talk by Avner Mandelman at the Ben Graham centre for value investing in Ontario - http://www.bengrahaminvesting.ca/Teaching_Applications/Guest_Speakers/2007_speakers.htm

I recall cringing a little at some of the methods he described (eg buying the county court secretary coffee and discussing legal cases, the Judge's mood etc). But some of it makes good sense - analysts shouldn't always rely on what the filings state - getting a feel for the character of a prospective business partner is always important.

This particular situation might warrant more investigation, but it could just be one of the many legal, but not very good business operations out there.

However the inference is difficult to pin-point. Sometimes as you accumulate information you get to a point where an alarm goes off in your mind "something is not right". It is not exactly about the parking lot thats empty at 5pm, nor about extravagant lifestyle of the CEO or his son/daughter/wife/mistress.

Also due allowance must be made for cultural differences and personal biases. In some cultures it is ok to be "loud" or pompous in others it is not. Infidelity, naturally, is inexcusable. But being a judge is difficult. You must apply the right scale to the fellow.

Taken in isolation each of the incidents may not raise a flag, however if it does then I guess you must heed it.

Either they had spare capacity from ambitious initial investment OR they have a slick OEM arrangement with another cloud provider, which would result in variable cost increases in parallel to the surge in revenue.

However, I would agree this case and the industry as a whole is at a strange Enron-style era of hype. Nobody is going to publish a true P&L for cloud infrastructure as under-subscription is a global reality thus far.

And there are a lot of wing-nuts willing to criticize your use of storage terminology, but how many of them know what fixed costs are?

1) The analysis of the firm is certainly not flattering but it's also not damning, meaning no discernable catalyst appears to be in place so I'd move on and keep an eye out for key developments, if any, happen to emerge. In terms of an investment decision, I'd place this in the "too hard" box to revist at a later date, but intellectually, it's fun to think about.2) Mosaic theory is an obvious defense but not the best--I'd consult a reputable insider trading/securities lawyer to understand the boundaries of the legal concept and to test the legality of one's methods and document them to protect yourself against potential future allegations of insider trading. And document any material information that may emerge in your investigation, too, in order to have a verifiable chronology of events. 3A) Reliability of signals--personally, I feel that character cannot be turned on & off like a light switch so observations drawn from private life will most likely lead to reasonable inferences on the individual and how he may run the corporation. As a counter-example to other posters, Phil Fisher led a relatively humble life but I think he did OK for himself financially.3B) While the father is fair game, I feel that watching the kid is out of line on the basis of the following role reversal: if a paid informant (spy? professional observer?) watched my (hypothetical) kid, I'd take issue with it even if I had nothing to hide. Of course, I'd want to understand the why behind it and ask nicely for them to stop but also prepare to press legal action if the pattern continued because the child has no direct material impact on management decisions at the firm.5) Personally, I'd be most intrigued to chat with the former manufacturing CEO to understand why he left his former job to work at this co, why he left and the nature of his working relationship with the founder while there.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.